We are economists writing about economics: Karl Smith, an assistant professor of economics and government at the School of Government at the University of North Carolina; and Adam Ozimek, an associate at an economics consulting firm. As most in our profession are eager to tell you, economics includes just about everything, so we'll be blogging -- with varying degrees of success -- about the economy, markets, politics, science, technology, philosophy and culture. We both come from a similarly vague libertarian ideological perspective, but we've been called neoliberal as well, and idiosyncratic might be the best adjective to use.

Yes Virginia, US Oil Production Can Influence Global Prices

A truism, tacked on to the end of any respectable article, blog post or research memo on US Oil Production, is that the US only produces a small fraction of the World’s Oil Supply and that as such it can’t influence prices. Ben Casselman’s post at the Wall Street Journal is a sterling example of respectable reporting. After noting that booming oil production in the US overwhelmed pipeline infrastructure; led to an usual divergence between the price of oil in the central US and the price of oil on the East Coast; and that railroads and new pipelines have begun to solve that infrastructure problem he ends:

The result: The gap between the two prices has narrowed to under $10 per barrel.

In other words, rising U.S. production is having a moderating effect on global prices. But don’t expect to see a big impact at your local filling station. The fracking boom has boosted U.S. production by roughly 2 million barrels per day over the past five years. That’s a big increase by domestic standards, but it represents just over 2% of worldwide oil consumption — hardly enough to cause a big drop in prices

There are a couple of ways to tackle this. One is to note that the US produces roughly the same amount of Petroleum Liquids (a bigger category than crude oil) as Saudi Arabia. Yet, conventional wisdom had been that Saudi Arabia more or less controlled the global price of oil and gasoline by altering how much it supplied to the markets. If the Saudis cut production oil prices, went up. If the ramped up production then oil prices went down. How can this be if they control roughly the same market share as the US?

The answer is that the price of oil is determined not by the overall amount of oil produced and consumed but by whether slightly more oil is being produced than consumers want to buy or slightly less. If slightly more is being produced then stockpiles will rise larger and larger over time. Stockpiles can’t keep growing forever and as they build larger and larger, vendors become eager to sell and cut the price. Similarly, as stockpiles shrink closer to zero, vendors become nervous that they will run out and raise the prices.

Folks can tack as much or as little cynicism about price gouging and manipulation, as there wont determines. Anyway you slice it, however, the fundamental limit here is that when the tanks are full you cannot accept deliveries and when the tanks are dry you cannot sell to consumers. Price has to change to keep those boundaries from being hit.

So, the US doesn’t have to produce so much oil that it radically expands global production. It just has to produce enough to tilt the tanks towards filling up, rather than emptying out.

If we go to the charts, it looks like that is exactly what is happening. Below is the daily price of oil produced in the Central US, West Texas Intermediate (WTI) in blue and the oil used by East Coast refineries, Brent Crude.

The two follow each other closely until about 2011. The US fracking boom had started well before then. However, that’s when oil started to pile up at Cushing, OK. The price of oil is pushed around by many factors but its fair enough to say that the price of WTI (blue line) continued to sink throughout most of 2011 as the storage depots in Cushing, Oklahoma became increasingly close to full capacity.

In late 2011 Enbridge announced plans to reverse one its pipelines that moved oil from the Texas coast to Cushing. Reversing the flow direction of a pipeline is no small matter, and the announcement helped ease concern that Cushing would hit capacity. As a result the blue line rose close to the red line again.

However, US production kept going and the Enbridge reversal was not enough. Over time the gap between WTI and Brent opened up again. Only recently, have it begun to close. Yet, this time its closing the other way. Brent is coming towards WTI. The result is that consumers are seeing a reduction in prices, related to the US supply boom.

Lets add gas prices to our chart and zoom in

The green line is the price of gasoline (minus 49 cents for the average US tax.) With a bit of a delay and some diversions due to refinery outages, the green line follows the red line. The price of gasoline is determined by the price of Brent. And, since the beginning of this year the price of gasoline has slowly been coming down, even though the price of WTI has barely changed. In the coming weeks the price of gasoline is likely to fall even more. There are currently some refinery outages in California and gasoline moves with a delay. This will save consumers money at the pump, and its happening as the price of Brent converges on to the price of WTI.

What that implies is that US production is beginning to set the world price and the price that consumers pay. The US is in economists terms – the marginal producer. This state of affairs may not last long. The Saudis may attempt reassert their role. Demand in Asia could pick up beyond what US production can meet, etc.

However, its not clear that this will happen. Asian growth is weakening. Iranian oil production is limited by sanctions. Both factors complicate the Saudis attempts to control prices. The landscape could continue to shift in this direction. As it does, price will increasingly be set by the marginal producer and the marginal producer righ,t now, is US fracking operations.

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